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EOQ for production lots

EOQ with quantity discount


Safety Stock
Periodic review system

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Inventory
Management

Model II: EOQ for


Production Lots

Used to determine the order size,


production lot.
Differs from Model I because orders
are assumed to be supplied or
produced at a uniform rate (p) rather
than the order being received all at
once.
06 July 2012

KLE College of Pharmacy, Nipani.

Inventory level

Production Order Quantity


Model
Part of inventory cycle
during which production
(and usage) is taking place
Demand part of cycle
with no production

Maximum
inventory

Time
Figure 12.6

Inventory
Management

Model II: EOQ for


Production Lots

It is also assumed that the supply


rate, p, is greater than the demand
rate, d
The change in maximum inventory
level requires modification of the TSC
equation
(D/Q)S
2DS p +
TSC = (Q/2)[(p-d)/p]C
EOQ =

p d in
The optimizationC results
06 July 2012

KLE College of Pharmacy, Nipani.

Inventory
Management

Example: EOQ for


Production Lots

Highland Electric Co. buys coal from


Cedar Creek Coal Co. to generate
electricity. CCCC can supply coal at
the rate of 3,500 tons per day for
$10.50 per ton. HEC uses the coal at
a rate of 800 tons per day and
operates 365 days per year.
06 July 2012

KLE College of Pharmacy, Nipani.

Inventory
Management

Example: EOQ for


Production Lots

HECs annual carrying cost for coal


is 20% of the acquisition cost, and
the ordering cost is $5,000.
a) What is the economical production
lot size?
b) What is HECs maximum inventory
level for coal?
06 July 2012

KLE College of Pharmacy, Nipani.

Inventory
Management

Example: EOQ for


Production Lots

Economical Production Lot Size


d = 800 tons/day;
D = 365(800) =
292,000tons/year
p = 3,500 tons/day
S = $5,000/order.,
C = .20(10.50)= $2.10/ton/year

EOQ = (2DS/C)[p/(p-d)]

EOQ = 2(292,000)(5,000)/2.10[3,500/(3,500-800)]
=

42,455.5

06 July 2012

tons per order


KLE College of Pharmacy, Nipani.

Inventory
Management

Example: EOQ for


Production Lots

Total Annual Stocking Cost (TSC)


TSC = (Q/2)((p-d)/p)C + (D/Q)S
= (42,455.5/2)((3,500-800)/3,500)
(2.10)
+ (292,000/42,455.5)(5,000)
= 34,388.95 + 34,388.95
Note: Total Carrying Cost
=
$68,777.90

equals Total Ordering Cost

06 July 2012

KLE College of Pharmacy, Nipani.

Model III: EOQ with Quantity


Discounts
Under quantity discounts, a supplier offers a
lower unit price if larger quantities are ordered
at one time
This is presented as a price or discount
schedule, i.e., a certain unit price over a certain
order quantity range
This means this model differs from Model I
because the acquisition cost (ac) may vary with
the quantity ordered, i.e., it is not necessarily
constant
. . . more

Model III: EOQ with Quantity


Discounts
Under this condition, acquisition cost
becomes an incremental cost and must be
considered in the determination of the EOQ
The total annual material costs (TMC) =
Total annual stocking costs (TSC) + annual
acquisition cost

TSC = (Q/2)C + (D/Q)S + (D)ac


. . . more

Model III: EOQ with Quantity


Discounts
To find the EOQ, the following
procedure is used:
1. Compute the EOQ using the lowest
acquisition cost.
If the resulting EOQ is feasible (the
quantity can be purchased at the
acquisition cost used), this quantity is
optimal and you are finished.
If the resulting EOQ is not feasible, go to
Step 2

2. Identify the next higher acquisition

Model III: EOQ with Quantity


Discounts
3. Compute the EOQ using the acquisition cost
from Step 2.
If the resulting EOQ is feasible, go to Step 4.
Otherwise, go to Step 2.

4. Compute the TMC for the feasible EOQ (just


found in Step 3) and its corresponding
acquisition cost.
5. Compute the TMC for each of the lower
acquisition costs using the minimum allowed
order quantity for each cost.
6. The quantity with the lowest TMC is optimal.

Example: EOQ with Quantity


Discounts
A-1 Auto Parts has a regional tire warehouse
in Atlanta. One popular tire, the XRX75, has
estimated demand of 25,000 next year. It
costs A-1 $100 to place an order for the tires,
and the annual carrying cost is 30% of the
acquisition cost. The supplier quotes these
prices for the tire:
Q ac
1 499 $21.60
500 999 20.95
1,000 + 20.90

Example: EOQ with Quantity


Discounts
Economical Order Quantity

EOQi = 2DS/Ci

EOQ3 = 2(25,000)100/(.3(20.90) = 893.00


This quantity is not feasible, so try ac = $20.95

EOQ 2 = 2(25,000)100/(.3(20.95) = 891.93


This quantity is feasible, so there is no reason
to try ac = $21.60

Example: EOQ with Quantity


Discounts
Compare Total Annual Material Costs (TMCs)
TMC = (Q/2)C + (D/Q)S + (D)ac
Compute TMC for Q = 891.93 and ac = $20.95
TMC2 = (891.93/2)(.3)(20.95) +
(25,000/891.93)100
+ (25,000)20.95
= 2,802.89 + 2,802.91 + 523,750
= $529,355.80
more

Example: EOQ with Quantity


Discounts
Compute TMC for Q = 1,000 and ac =
$20.90
TMC3 = (1,000/2)(.3)(20.90) +
(25,000/1,000)100
+ (25,000)20.90
= 3,135.00 + 2,500.00 + 522,500
= $528,135.00 (lower than TMC2)
The EOQ is 1,000 tires
at an acquisition cost of $20.90.

SAFETY STOCK
Is required to be considered in some conditions
They Arise
because
In practical situation
Demand of items may fluctuate at any point of
time
And also suppliers always need some lead
time to supply the goods

Lead time can easily be provided to supplier by


placing order before inventory become zero.
e.g.
Lead time is 10 days , so order can be placed 10
days before it becomes zero. Let the uniform
consumption of inventory be 50 units per day
therefore during the 10days of lead time 500 units
will be consumed . Hence ROL can be fixed at 500
units.
A
Stock out may occur sometime due to either
excessive consumption or due to undue stretching of
lead time
We know stock out is undesirable for the various
reasons so to avoid it extra stock is maintained
throughout thr year. This is called as Safety Stock

Inventory decreases at constant


I
n
v
e
n
t
o
r
y
L
e
v
e
l

rate

Re order level

Q
500 units
Lead Time

10days

First Order

Second Order

Goods Received

Lead time being provided by fixing a reorder level

Inventory decreases at constant


I
n
v
e
n
t
o
r
y
L
e
v
e
l

rate

Re order level

Q
500 units
7 days

Lead Time

10days

First Order

Second Order

Goods Received
Excessive consumption of inventory during the lead time, leading
L to stock out

Inventory decreases at constant


I
n
v
e
n
t
o
r
y

rate

Re order level

L
e
v
e
l

500 units
7 days
Lead Time

800 units

Second Order
Goods Received

Safety Stock

Safety Stock avoids a stock out caused by excessive consumption


of inventory during lead time

But lets have one understanding


A low level of safety stock can lead
to a stock out. On the other hand a
high level of safety stock
unnecessarily ties up capital.
Therefore we need to determine the
optimum level of safety stock. Which
should neither be low nor high.

Lets do one practical

Safety stock involves two types of costs:


1. CC carrying cost of safety stock
2. SC stock out cost
These cost are inversely related to each other
CC safety stock 1/Stock out cost
High the safety stock high CC low the chance of SC.
Research shows that the total cost of safety stock is
minimum only when
CC safety stock = SC safety stock
Lets take an example keeping normal lead time
constant .
Demand during lead time may vary leading to
possibility of stock out.

Practical- CASE of NESTLE


A local chocolate distributor at
Ghaziabad deals with a popular
brand called chocostick. The
normal lead time taken by the
supplier of chocostick is 10
days . The normal consumption
of inventory during the lead
time is 500 units per day. there
are 10 inventory cycles per
year. The CC is Rs.1 per unit
per year. The stock out cost is
Rs.2. per unit short. Mr. Ram
the sales man gives you a
consumption pattern of
chocostick ( based on his past
100 observations)
Find the optimum level of
safety stock for chocostick.

Consumption
during lead time
(units)

Probability

1000
2000
3000
4000
5000
6000
7000
8000

.01
.03
.07
.14
.61
.04
.07
.03
1.00

Crux of the case:


See they have given normal lead time of supplier
and also consumption during the lead time that too
at normal rate.
He had analyzed the pattern of the demand during
lead time .
He understand one fact very clearly stock out will
cost double of the carrying cost.
So normal consumption of chocostick during the
lead time = 10 days X 500 units/day=5000 units
As per observations out of 100 consumption during
lead time is 5000 unit or less 86 times.(86 =
61+14+7+3+1)
Therefore if no safety stock is maintained there is
an 86% chance that a stock out will not happen.
But still the problem is HOW MUCH safety stock.

Lets understand the crux of the other part


CASE 1. No safety stock: then stock out will be there
only when DDLT exceeds 5000 units. i.e
6000/7000/8000 with stock out of 1000/2000/3000
CASE 2. 1000 units of safety stock : then stock out at
DDLT exceeds 6000 units
CASE 3. 2000 units of safety stock : then stock out at
DDLT exceeds 7000 units
CASE 4. 3000 units of safety stock: then stock out
will only when DDLT exceeds to 8000 units.
So to arrive at the optimum safety stock you need to
understand that at what level of safety stock your
inventory cost i.e carrying as well as stock out cost
will be minimum.

Lead time
consumption
leading to stock
out

NO. of units
short

Probability

Expected annual stock out


cost. (RS.)

6000

1000

.04

10X1000X.04X2 = 800

7000

2000

.07

10X2000X.07X2 = 2800

8000

3000

.03

10X3000X.03X2 = 1800
5400.00

7000

1000

.07

10X1000X.07X2 = 1400

8000

2000

.03

10X2000X.03X2 = 1200
2600.00

1000

.03

10X1000X.03X2 = 600
600.00

Case1.

Case 2.

Case 3.
8000

Comparison
Safety stock
levels (units)

CC of safety
stock (Rs.)

Stock out Cost


(Rs.)

Total safety
Stock Cost(Rs.)

5400.00

5400.00

1000

1000.00

2600.00

3600.00

2000

2000.00

600.00

2600.00

3000

3000.00

3000.00

Safety Stock(other method)


Use safety stock to protect against stockouts when demand
or lead time is not constant.(based on service level)
Safety stock = z x sd
z is from Standard Normal Distribution Table and is based
on P = Probability of being in-stock during lead time.
ROP = expected demand during lead time + safety stock
= d x LT + z x sd

, Sd= Sd

* square root of LT

Average Inventory
Level (AIL) = regular stock + safety stock
Q
AIL =
+ z x sd
2
29

monthly demand forecast(d)


= 11,107 units
Standard deviation (sd)
= 3,099 units
Lead time (Lt)
= 1.5
months
Probability of available inventory =75%
Sol:
ROP= d*LT + Z(sd)
sd=sd L = 3,099 * =3,795
Z=0.67
from area under the standard normal
distribution
ROP=11107 *1.5 +(0.67*3,795)= 19,203

Periodic Review System

Figure 11.8 Periodic review system: units in stock versus time

Target Level or
Maximum Inventory Level
Total of the:
demand (D) during the review period
(R)
+ demand (D) during the lead time (L)
+ safety stock (SS)

T = D(R + L) + SS

Periodic Review Order Quantity


When it is time to place an order
Order the difference between the target
level (T) and the quantity on hand (I ).

Q=T-I

Periodic Review System


Used when:
there are many small issues from stock
e.g. grocery stores
many items are ordered from one source
many items are ordered together to fill a
truck or a production run

Periodic Review - Example


Problem
A harware company stocks nuts and bolts and orders them from
a local supplier once every two weeks (10 working days). Lead
time is two days. The company has determined that the average
demand for 1/2 inch bolts is 150 per week (5 working days), and
it wants to keep a safety stock of three days supply on hand. An
order is to be placed this week, and stock on hand is 130 bolts.
a. What is the target level?
b. How many 1/2 inch bolts should be ordered this time?
Let:
D= demand per unit time = 150 / 5 = 30 per working day
L = lead time = 2 days
R = review period = 10 days
SS = safety stock = 3 days supply = 90 units
I = inventory on hand = 130 units

Periodic Review Example Problem Continued


Target level T = D(R + L) + SS
= 30(10 + 2) + 90
= 450 units
Order quantity Q = T - I
= 450 - 130
= 320 units
Place an order now for 320 units which will arrive in
2 days.

Pull Inventory Control - Repetitive Ordering


For perpetual (continual) demand.
Treat each stocking point independently.
Consider 1 product art 1 location.
Reorder

Determine:

Periodic

Point System

Review System

How much to order:

T-I

When to (re)order:

ROP

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